Monday, October 6, 2008

Financial Weapons of Mass Destruction

Last evening, 60 Minutes aired a segment on the "Shadow Market" of Credit Default Swaps".

Bear with me for a minute with this, but the technical definition of a credit default swap (CDS) is a contract in which a buyer pays a series of payments to a seller, and in exchange receives the right to a payoff if an associated credit instrument goes into default or on the occurence of a specific credit event named in the contract (such as bankruptcy or restructuring). The associated instrument does not need to be associated with the buyer or the seller of this contract.
Originally used as a form of insurance against bad debts, these instruments became a tool for financial speculation when the Commodity Futures Modernization Act of 2000 , signed by president Bill Clinton, specifically barred regulation of these trades.

What the heck does this mean and why is it important in light of the financial crisis? I am not an economist and have never worked in the financial industry, but I will attempt to explain as I understand it, in simple terms.

With a global flush of cash looking for a home, Wall Street financial institutions bought up mortages, chopped them up into tiny chunks and sold them as mortgage backed securities to gobs of willing investors. As more and more sub-prime mortgages came into the market, the math geniuses at rating agencies came up with complex algorithms which were supposed to assess the risk of each security so they could be sold off in rated tiers and spread the risk around. To offset risk, particularly with the lower rated securities, credit default swaps were sold along with the securities. These CDSs are basically a form of insurance against a security should it defaut or should the seller go into bankruptcy. Because they are termed "swaps", they are not subject to insurance regulations, which would require that the insurer actually have capital to back up the insured product. Prices for the CDSs varied based on the degree of risk, and Wall Street made a fortune selling these so-called "derivatives", valued at $60 TRILLION, without having to put aside the funds to back them up. CDSs became the most widely traded derivatives on the market, and investors all over the globe bought them. When people began to default on their mortgages, the financial institutions such as Bear Stearns and Lehmen Brothers did not have the capital to fund these liabilities, and went bust. This doesn't make the unfunded liabilties of $60 trillion go away. Someone has to pay for them, and it's one of the many reasons why the crisis continues to spiral out of control globally despite Congress' intervention with the $700 bailout.

Warren Buffet famously called these CDSs "Financial weapons of mass destruction", and has warned against them for years. So my question is "Why didn't the members of Congress see this train wreck coming?" Anyone with half a brain knows that you can't guarantee to insure something if you don't have the funds to back it up. What were all of the members of the banking, financial and insurance sub-committees in Congress doing? Were Senators Dodd, Shumer, Frank, Reed, and others asleep at the wheel, or did they intentionally turn their heads the other way, so as not to upset their big money donors who made gazillions with this Ponzi scheme? At best, it's criminal negligence; at worst, it's conspiracy to commit fraud, ultimately at the taxpayers expense. And what about Phil Gramm, godfather of CDS's? Why aren't they going to jail?

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